Chapter 11 Depreciation Depreciations: Straight Line Sum of Years Digits Declining Balance

Depreciation is important because it affects the taxes that firms pay. The taxable income is (PROFIT – COSTS). Taxes are proportional to this taxable income. Depreciation works as a decrease in the value of an asset each year. Depreciation adds to the cost and therefore reduces the taxable income. In other words, depreciation is considered as a deduction from the taxable income. Thus the greater the depreciation, the less the taxable income – hence taxes.

Depreciation: Example A firm has $1,000,000 of taxable income. If its tax rate is 20%, the firm would pay $200,000 in taxes (without considering the effect of depreciation). If the firm can deduct $50,000 in depreciation charges, its net taxable income will be $950,000. Thus, it would pay taxes of 0.20 (950,000) = $190,000. Depreciation saves 200,000 – 190,000 = 10,000 = 0.20(50,000). Therefore, a firm wants to choose the depreciation method that will minimize its taxable income.

Depreciation Important reasons for depreciation include deterioration,    obsolescence. Depreciation can mean a decrease in market value, a decrease in the value to the owner.  Accountants define depreciation as follows: The systematic allocation of the cost of an asset over its depreciable life. The last definition is the one used for determining taxable income – hence, income taxes. Thus, this definition is most important to us. Market value is the value others would place on the property of interest

Depreciation: Requirements In general business assets can only be depreciated if they meet the following basic requirements: The property must be used for business purposes to produce income The property must have a useful life that can be determined, and this life must be longer than one year The property must be an asset that decays, gets used up, wears out, becomes obsolete, or loses value to the owner from natural causes.

Example: 11-1 Joe runs a local pizza business. Identify each cost as either expensed or depreciated and describe why. Cost Item Type of Cost Reason Pizza dough, toppings Expensed Life < 1 yr, loses value immediately Delivery van Depreciated Meets 3 depreciation requirements* Employee wages Furnishings for dining room Meets 3 depreciation requirements New baking oven Utilities for refrigerator Expensed Items such as: Labor, Utilities, Materials, Insurance Expensed items are (often recurring) expenses in regular business operations. They are consumed over short periods (e.g., monthly or biweekly salaries). When expenses occur, they are subtracted from business revenues for tax purposes. An accountant writes off their full amount when they occur, hence they will reduce the income taxes. Depreciated Items: van, furniture, baking oven, cash register, computer. Usually you pay for the asset at the beginning, but depreciate it over time; i.e. the asset loses value gradually. Such loss should written off over an extended period of time.

Depreciation: Overview Definition. The number of years over which a machine is depreciated is called its depreciable life or recovery period. This period may differ from the useful life. Depreciated assets may operate well beyond their depreciable life. Depreciable life is determined by the deprecation method used to spread out the cost. At least six different depreciation methods are available. Depreciation is a non-cash cost. The government allows the use of such cost to offset the loss in value of business assets Usually you pay for the asset up front (initial cost), but depreciate it over time (e.g., a new truck). Depreciation is simply a way to claim these business expenses over time to finally reduce the income taxes. Important to the engineering economist on an after-tax basis because it changes the cash flows due to taxes

Classes of Business Property Almost all tangible properties can be depreciated as business assets Classes of Business Property Tangible property can be seen, touched, and felt. (It is “tangible.”)  Real property (think “real estate”) includes land, buildings, and all things growing on, built on, constructed on, or attached to the land. Personal property includes equipment, furnishing, vehicles, office machinery, and anything that is tangible excluding those assets defined as real property. (“personal” does not refer to being owned by a person or being private.) Intangible property is all property that has value to the owner but cannot be directly seen or touched. Examples include patents, trademarks, trade names, and franchises. Examples of depreciable business assets: Copy machines, Helicopters, Buildings, Interior furnishing, Production equipment, Computer networks Many different types of properties that wear out, decay, or lose value can be depreciated as business assets. Examples of nondepreciable business assets: Land: it does not wear out, lose value, or have a determinable useful life. Indeed, often it increases in value. Leased property: only the owner of property may claim depreciation expenses. Sometimes tangible property is used for both business and personal activities, such as a home office. The depreciation deduction can be taken only in proportion to the use for business expenses.

Depreciation Calculation Fundamentals Year Depreciation Book Value $1,500 1 $500 $1,000 2 $400 $600 3 $350 $250 Example. A PC costs $1,500. Its annual depreciation charges are $500, $400, and $550 for three years. $1,500 is called the cost, initial cost, or cost basis. dt denotes the depreciation deduction in year t. Thus d1 = $500, d2 = $400, d3 = $350. BVt denotes the book value at the end of year t. BV0 = cost basis , which is the $1,500 BV1 = BV0 – d1 = cost basis – d1 , which is the $1,000 BV2 = BV1 – d2 = cost basis – (d1 + d2) , which is the $600 BV3 = BV2 – d3 = cost basis – (d1 + d2 + d3) , which is the $250

Book value = Cost – Depreciation charges made to date BVt = cost basis – (d1 + d2 + … + dt) where BVt is the book value of the depreciated asset at the end of time t This equation is used to compute the book value of an asset at the end of any time t. Check figure 11.1 in your book to see how depreciation is viewed over time. Book value can be viewed as the remaining unallocated cost of an asset:   Note: If the item has a salvage value then the final book value will be the salvage value. Example: The book value of the PC declines during the useful life from a value of B = $1,500 at time 0 in the recovery period, to a value of S = $250 at time 3. Numerous depreciation methods are possible.

Historical Depreciation Methods They are the methods that we will study in this chapter. We will not cover other methods 1) Straight line, 2) Sum-of-the-years digits, and 3) Declining balance. Each method requires estimates of the asset’s useful life and salvage value. Firms could choose the method. 

Straight Line (SL) Depreciation Example 11.2 An asset has a cost of B = $900, a depreciable life of N = 5 years, and a salvage value of S = $70. Compute the straight-line depreciation schedule With straight line depreciation, we would compute the following: Annual depreciation charge: di = (B-S)/N = 830/5 = $166.  The book value of the asset decreases by $166 each year Book Value Initial Cost 900 Salvage Value 70 Year t Depr. Charge for year t (dt) Sum of Depreciation charges up to year t EOY Book Value $900 1 $166 734 2 332 568 3 498 402 4 664 236 5 830 Salvage Value 70 Total Depr.: $830 1 2 3 4 5 N

Sum-Of-Years Digits (SOYD) Depreciation Example 11-3 An asset has a cost of B = $900, a depreciable life of N = 5 years, and a salvage value of S = $70. With SOYD depreciation, we would compute the following Year Multiplier Depreciation Charge (dt) Sum of Depreciation charges up to year t Book Value at end of year t (BVt) $900 1 5/15 $277 623 2 4/15 221 498 402 3 3/15 166 664 236 4 2/15 111 775 125 5 1/15 55 830 70 The product of the multiplier and B-S for the year is the depreciation charge for the year. Note the multipliers add to 1.

Sum-Of-Years Digits (SOYD) Depreciation   dt=[(N+1-t)/SOYD](B-S) SOYD = N(N+1)/2 (which is the sum of years’ digits; i.e. 1+2+3+4+5 in our example) Book Value SOYD depreciation causes larger decreases in book value in earlier years than in later years. SOYD Depreciation looks like this. $S Depreciable life = N years

Declining Balance Depreciation For straight line depreciation with N years, the rate of decrease each year is 1/N. Declining balance depreciation uses a rate of either 150% or 200% of the straight-line rate. Since 200% is twice the straight-line rate, it is called double declining balance (DDB). The DDB equation for any year is DDB depreciation dt = (2/N) ( Book valuet-1)  Book value = Initial cost – total charges to date,  So, DDB deprec. dt = (2/N) (Initial cost – total charges to date) It can be shown for DDB, that the depreciation schedule in year t is given by: DDB depreciation in year t = (2B/N)(1 – 2/N)t-1 For 150% declining balance depreciation, the depreciation in year t is given by: DDB depreciation in year t =(1.5 B/N)(1 – 1.5/N)t-1.  we just replace each “2” in the DDB formula by “1.5”.

Declining Balance Depreciation: Example Example 11-4 An asset has a cost of B = $900, a depreciable life of N = 5 years, and a salvage value of S = $70. Compute the DDB depreciation schedule Year Multiplier Depreciation Charge (dt) Sum of Depreciation charges up to year t Book Value at end of year t (BVt) $900 1 2/5 $360 540 2 216 576 324 3 130 706 194 4 78 784 116 5 46 830 70 If the salvage value of this example had not been $70, a modification of DDB would be necessary. Several modification possibilities exist: stop further depreciation when the book value equals the salvage value; switch from DB depreciation to straight line.